More clarity sought on CCP insurance offer

The uptake of insurance by clearing houses will come down to cost and
robustness, Marcus Zickwolff,
head of trading and clearing at Eurex Group, says.

About 20
insurance companies have been brought together by New York-based GCSA LLC to
offer coverage to clearing houses processing millions of derivatives trades in
case of default.

The focus
on clearing houses’ ability to withstand a failure has increased following
reforms requiring liquid OTC derivatives trades to be cleared through a central
counterparty (CCP). The move has raised concerns market risk has now been moved
from banks to CCPs.

Zickwolff, who is also the
chairman of the European Association of CCP Clearing Houses, told
theTRADEnews.com CCP insurance could be one of the tools in a recovery or
resolution plan.

“However, I wonder if insurance companies are able to model the probability of
clearing house failure and can ensure immediate and unconditional pay-out in such
a scenario,” he said.

In the case of clearing member default, CCPs need immediate liquidity,
Zickwolff said. “It’s hard to imagine that an insurance company would be
immediately and unconditionally able to provide sufficient funding."

He said most CCPs, such as Deutsche Börse-owned Eurex Clearing, have the
backing of a mother company that could step in if all lines of defence failed.
“Of course, a CCP may find it more attractive to rely on an insurance service –
it really depends on the economics and robustness of the insurance offer.”

Education needed

If a member
was to go bust, CCPs would first use the margin posted by that counterparty, then
use some of its own equity, before diving in to members’ default fund
contributions.

Under the
proposed insurance solution, when all default funds were exhausted, the GSCA
and its group of insurers would then step in.

Christopher
Cononico, founder of GCSA, said insurance brings diversification and has been
used in a default waterfall before.

“We’ve
tried to be innovative in coming up with twists on traditional insurance to
make sure it’s customised for clearing.”

He said insurance
companies within the group were the primary risk takers and there would be no “endless
chain of re-insurance”.

Addressing Zickwolff’s concern about immediate access to
funds, Cononico said the role of insurance companies was to absorb losses, but the group could work with CCPs to get money fast.

CCPs with unsecured liquidity facilities could provide liquidity
immediately and the insurance companies would then pay those back, he said.

“Another
idea was having collateral insurance, which is something that the insurance
group could post to a committed secured credit facility to assist a clearing
house in getting immediate access to funds.”

Cononico
said there has been a lot of enthusiasm from CCPs, but GCSA was still working
on explaining how the process would work.

“Right now,
we’re focused on making sure we work closely with all the stakeholders and put
something out there that works for each client independently.”

Recent history

There have
been three examples of CCP failures in the past 40 years.
French CCP Caisse de Liquidation went down in 1974, as result of clearing
members defaulting on margin calls due to a free fall in the price of sugar
futures.

In 1983,
the Kuala Lumpur Commodities Clearing House failed when palm oil futures prices
caused a number of large broker members to default. And four years later, Black
Monday led to the failure of the Hong Kong Futures Exchange clearing house,
sparking a bailout of its holding company by the government and a number of
large financial institutions.

Virginie
O’Shea, senior analyst at Aite and author of a recent report on OTC derivatives
clearing said the incidents explain why regulators are so focused on default
fund contributions, particularly following the arrival of OTC derivatives
clearing.

“There has
been a lot of communication on default funds and whether they are big enough,” she
said.

The
Committee on Payment and Settlement Systems and the International Organization
of Securities Commission released 24 principles for systematically important market
infrastructures, including CCPs, in 2012, addressing clearing houses increased
importance in the market and the need for default procedures.

The Bank of
England, which assumed responsibility for regulating local CCPs and securities
settlement systems in April 2013, has also been closely monitoring clearing
houses.

Last week,
the central bank released an update report that found all UK CCPs have now
introduced arrangements to manage clearing member default losses that exceed
their pre-funded resources.

“There is some pressure on central banks to
step in and prevent a crisis,” O’Shea said. “And questions remain on whether
the insurance route is going to be robust enough. Insurers are not exposed to
the derivatives market, so there is one degree of assurance.”

O’Shea said
uptake of CCP insurance would come down to price or pressure from regulators
and members.

“How will
they get the money to put aside for insurance? I’m not sure. It’s another thing
to add on top of a list of things they’re asked to hold capital for. CCPs want
to be seen publicly as taking precautions, but the costs could add up and put
them out of business,” she said.